By Thomas J. Murphy
Murphy Law Firm, Inc.
Presented to Lorman Education Services’
The New Era of Estate Planning in Arizona
July 19, 2011
The enactment of the Arizona Trust Code (“ATC”), effective January 1, 2009, has clarified several murky areas of estate planning law and provided some new techniques for estate planners. While nothing in the new code changes the traditional and customary techniques of estate planning, it does open up some new planning possibilities. The purpose of these materials is to discuss some of those new techniques.
Trust as beneficiary of life insurance policy
ARS 14-10504(d) provides that a trust will qualify for protection under ARS 20-1131 and 33-1126 if the beneficiary named in the trust would be entitled to protection if the beneficiary had been named as outright beneficiary.
Prior to the ATC’s enactment, there was doubt that a trust would qualify for the creditor protection afforded a beneficiary of the death benefit of a life insurance policy. The problem was that ARS 20-1131 only provided protection to a “person”. ARS 20-105 defines a “person” as “an individual, company, insurer, association, organization, society, reciprocal or inter-insurance exchange, partnership, syndicate, business trust, corporation and entity”. While this is not necessarily an all-inclusive list, it was disturbing that revocable grantor trust was not listed. Over time, the consensus was that the typical living or revocable trust did not qualify.
ARS 14-10504(d) appears to alleviate this problem by stating:
- “A creditor of a trust beneficiary may not compel a distribution from insurance proceeds payable to the trustee as beneficiary to the extent state law exempts such insurance proceeds from creditors’ claims if it had been paid directly to the trust beneficiary.”
So, while a beneficiary’s interest can now be protected, there may an issue as to creditor protection afforded to surviving spouses. This is due to the potential problems created by ARS 20-1131. As discussed elsewhere in this seminar, the danger of creditors for a surviving spouse may be limited by naming a trust as beneficiary of the life insurance policy with the spouse as beneficiary of the trust.
Beneficiary as trustee
ARS 14-10504 has given a big creditor protection boost to discretionary trusts, especially with regards to a settlor’s children or other beneficiaries who may need the protection of a spendthrift trust. Subparagraph (e) has generated a great deal of excitement, which states:
- “A creditor of a beneficiary, whether or not the beneficiary is also a trustee or cotrustee, may not reach the beneficiary’s beneficial interest or otherwise compel a distribution if either the trustee’s discretion to make distributions for the trustee’s own benefit is purely discretionary or is limited by an ascertainable standard, including a standard relating to the beneficiary’s health, education, support or maintenance or similar language within the meaning of section 2041(b)(1)(a) of the internal revenue code”.
This now eliminates the longstanding problem of the doctrine of merger in which a trustee could not also be the primary beneficiary. The concept of a trustee-beneficiary was specifically approved by the drafters of the Uniform Trust Code (“UTC”) in the Comments and its primary objective was “to protect the trustee-beneficiary of a bypass trust from creditor claims”.
Practitioners will more often encounter this with a client who has a child in a bad marriage. Section 14-10503 will also come into play since the exceptions to spendthrift protection is apparently limited to child support, ie the exception does not apply to spousal maintenance. The statute is silent as to spousal maintenance, leading many commentators to conclude that the absence means it is not included in the spendthrift exceptions. Particularly noteworthy is that the companion sections 503 and 504 of the UTC that included spouses and former spouses in its list of excepted creditors. Also conspicuously absent are suppliers of necessaries and tort claimants who had been listed among the exception creditors in prior Restatements. This was not an oversight as the Comments to section 503 of the UTC make clear. Also noteworthy is section 14-10505 provides relief to the child but not the former spouse if the trustee has abused his/her discretion.
The comments to section 503 of the UTC state that the section “does not authorize (an exception creditor) to compel a distribution from the trust”. It just simply requires a trustee to pay the creditor, not the beneficiary, if and when a distribution is made. It only applies to distributions that would have otherwise been made, such as a mandatory distribution of income. It does not eliminate other obstacles that a creditor may have such as the trustee’s discretion in making distributions.
Also note that ARS 14-503 is limited to a child’s right to “support or maintenance”. It would appear that orders for money damages or restitution would not come within this limitation.
The tax consequences of these discretionary provisions still remain as a major consideration. If provisions in the trust are so broad that trustees have too much discretion over distribution of funds, beneficiaries may be treated by the IRS, under IRC sections 2041(b) and 2514(e), as having a general power of appointment equating to ownership of the trust property or triggering an IRC 2036 “power to control” argument resulting in inclusion in the trustee’s estate for estate tax purposes. Yet, it must be kept in mind that, if given outright to the beneficiary, the assets would be includable in his/her estate. But there is likely to be no adverse income tax consequence since, if the trustee is the only current beneficiary, the compressed trust income tax rates will normally lead to any trust income being carried out to the beneficiary anyway.
An overly broad discretionary standard can also have a non-tax downside since the standard may be left to interpretation by the courts, causing uncertainty.
Because of the IRC section 2041 issue, most of my colleagues recommend playing it safe with an ascertainable standard, providing for the lapsing of the power, placing limitation in the trustee’s ability to make distributions to themselves, their estates, their creditors or creditors of their estates or using a “five and five” limitation.
ARS 14-10505 again comes into play with asset protection, raising the bar for creditors. For instance, subparagraph (a)(2) states, in part that : “a creditor of a beneficiary may not compel a distribution that is subject to the trustee’s discretion, even if …. The trustee has not complied with the applicable standard of distribution or has abused the discretion regarding distributions”.
Likewise, ARS 14-10814 creates an additional hurdle for creditors, stating that “the trustee shall exercise a discretionary power in good faith as to only beneficiaries of the trust and creditors of the trust and no other persons, including creditors of the beneficiaries, except only to the extent that creditors of beneficiaries are expressly entitled to attachment”. This does not give any rights to a creditor to compel a distribution, only that the trustee must exercise good faith in its discretion as to an attaching creditor. See Scott & Fratcher, The Law of Trusts (4th ed.), section 155; section 154 of the Restatement (Second) of Trusts, comment b. The term “good faith” is not defined in the Code so that common law concepts and definitions will apply. The lack of good faith, according to Scott, amounts “capricious” or “dishonest” behavior or acting with “an improper motive”. Scott, supra, sec. 187.2.
The comments to the UTC, on which the Arizona Trust Code is based, together with the Restatement, make it clear that this is not an easy thing to do. Section 187 of the Restatement (Second) of Trusts & section 50 of the Restatement (Third). First, a creditor must establish what the discretionary standard is and demonstrate that the trustee has failed to comply with that standard. Second, the creditor has to show that the failure to make the distribution is an abuse of discretion. As stated in Danforth, infra, this is “a daunting task under any circumstances”.
ARS 14-10506 permits a trustee with withhold distributions, including mandatory distributions, to a beneficiary if “the terms of the trust expressly authorize the trustee to delay the distribution to protect the beneficiary’s interest in the distribution”.
ARS 14-10818(b)(2) authorizes the creation of a trust protector who has the power to “modify or amend the trust instrument for any valid purpose or reason”. Presumably protecting a beneficiary’s interests from a creditor would be a “valid purpose”.
Self-settled spendthrift trusts
Section 14-7705 of the prior trust code precluded the use of self-settled trust as an asset protection maneuver for the settlor. Arizona Bank v. Morris, 7 Ariz App 107, (1968); section 156 of the Restatement (Second). The new code has changed this. ARS 14-10505(a)(2) states: “with respect to an irrevocable trust, a creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit”. If the settlor limits his/her rights to, say, the income of the irrevocable trust but has no rights to the trust corpus, has that corpus been taken out of the reach of creditors? Commentators of the UTC state this is a major change, noting that conspicuously lacking in both the ATC and UTC is language to the effect that the spendthrift restraint “is invalid against transferees and creditors of the trust” as was contained in the old ARS 14-7705. (For a wide ranging discussion of this and other UTC creditor issues, see “Article Five of the UTC And The Future Of Creditors’ Rights in Trusts” by Robert T. Danforth in the April 2006 edition of Cardozo Law Review, 27 Cardozo L Rev 2551.)
All of this assumes there is no issue with a fraudulent conveyance, ARS 44-1001 et seq.